Mutual funds: everything you need to know
Home › Investments › Mutual funds
Deciding to invest is easy, but understanding where to invest can be tricky. With so many investment options available, many people find it confusing, and may end up investing their money somewhere that’s not right for their investment goals.
Mutual funds are amongst the most popular types of investment, with both beginners and experienced investors using them. On this page, you’ll learn everything you need to know about mutual funds, including how they work and what the risks, pros and cons are, so you can decide if mutual funds are the right investment option for you.
Mutual funds allow you to invest your money into a pool of capital together with other investors to purchase stocks, bonds or other securities
You don’t own securities from where the fund invests directly, but instead, you’re purchasing shares in the mutual fund itself
Mutual funds allow individual investors access to a diversified portfolio, and are typically professionally managed by a fund manager
What is a mutual fund?
Mutual funds allow you to invest your money into a pool of capital together with other investors, to purchase stocks, bonds or any other securities in a portfolio. The value of a mutual fund is known as the net asset value (NAV). This value is determined by the total value of securities in a portfolio, divided by the fund’s outstanding shares.
How does a mutual fund work?
When you decide to invest in a mutual fund, you don’t actually own securities from where the fund invests directly; you’re purchasing shares in the investment fund itself. A share in a mutual fund is representative of an investment in different securities, as opposed to trading stocks on an exchange yourself. Investors can earn returns from mutual funds in three different ways, which are as follows:
- Dividends – Some mutual funds have the option of earning dividends on the stocks and interest on bonds held in the portfolio. If that’s the case, each year, you’ll be given the option to receive your dividend distribution, or use it to reinvest into the fund and acquire more shares.
- Fund sales – When a fund sells securities that have increased in price, it makes a capital gain which can pass to investors through distribution.
- Individual sales – If the fund’s holdings increase in price, but they choose not to sell, you can decide to sell your mutual fund shares on the market.
Many funds have a fund manager who works in the best interest of the mutual fund’s shareholders. Fund managers may employ analysts to help them make accurate decisions on where to make the best investments.
What are the pros and cons of mutual funds?
Pros
- Mutual funds are typically managed by an experienced fund manager, who helps ease the hassle of making transactions and knows where to invest with the intent of garnering the best returns.
- The fund manager often offers dividends to investors, giving you the option to reinvest by purchasing additional shares.
- Mutual funds are considered lower risk than investment in a single security as the portfolio is diversified, and mutual funds often consist of 50 to 200 different securities.
- Mutual funds are easy to understand and start investing in. They typically have low minimum investments and fewer price fluctuations because they are only traded once per day.
Cons
- Mutual funds often have high expense ratios, sometimes as much as 1.2% or higher. ETFs are typically cheaper.
- A fund manager could abuse their power by making unnecessary trades.
- Capital gains payouts from mutual funds affect the distributions you may receive, and can have tax implications.
- Fees can be costly, as mutual funds are often expensive to manage. You may also be charged commissions and annual fees, regardless of the performance of the fund.
What are the different types of mutual funds?
Mutual funds are divided into categories, which are differentiated by the mutual fund’s portfolios and returns it seeks. The following are the common types of mutual funds:
- Equity funds – This type of mutual fund invests solely in stocks and has many subcategories. The size of the companies the fund manager invests in can be one category. It is defined by market capitalization from small cap stocks to large cap stocks. Other mutual funds are determined by their own and unique investment strategy, and still others by aggressive growth, income-oriented approach, value and more.
- Fixed-income funds – Fixed-income funds focus on investments that pay a fixed rate of return through government bonds, corporate bonds or other debt instruments. With this type of fund, the aim is to generate income through interest to pass on to the shareholders.
- Index funds – Index funds are a popular type of mutual fund. The investment strategy is to purchase stocks that are included in a major market index, such as the FTSE 100. Index funds often require no fund management, because their objective isn’t to beat the market, but to replicate it automatically
- Balanced funds – This type of fund invests in different asset classes, including stocks, bonds, money market instruments or any alternative instrument. Their main objective is to reduce risk by spreading investments across asset classes, sometimes evenly distributed or balanced.
- Money market funds – These funds aim to invest in safe or risk-free, short-term debt, mostly government treasury bills that are considered a safer place to invest your money than other types of mutual funds. You may not gain high returns, but you’re less likely to lose your investment.
- Income funds – Income funds are designed to provide a steady income and tend to invest in government and high-quality corporate debt. They hold bonds until they mature, to provide interest and offer a steady cash flow to investors. Other income funds can include stocks paying a high dividend.
- International or global funds – International funds invest in assets located outside your country of residence, while global funds invest anywhere across the world. If reduced to few countries, they are often more volatile and are subject to country-specific and political risks. Global investment diversification may reduce risk.
- Special funds – This type of mutual fund has a segmented or targeted strategy instead of diversity. For example, sector funds are a type of special fund which target specific sectors of the economy, such as finance, technology, or health. Regional funds focus on geographic areas, which makes it easier to purchase stocks in foreign countries. Socially responsible funds are another special fund that some consider ethical by investing only in companies that meet specific guidelines or beliefs.
Examples of mutual funds
Different types of mutual funds use different ways of investing your money, but they still have similarities in how you earn returns.
For example, let’s say you plan on investing in an investment company called “ABCInvesting”. You want to invest £2,000 into their mutual fund, and their NAV is at £20. ABCInvesting will give you 100 units of their mutual fund scheme.
After a year, the NAV of the mutual fund increases to £22, meaning that in one year, you’ve earned a 10% return on your investment for each unit you own.
What should I consider when opening a mutual fund?
Investing in mutual funds means you’ll need to determine which type of fund is most suitable for you and understand the individual risks they present and the strategy they use.
You’ll also need to consider the mutual fund’s NAV, as this may be the deciding factor for which type of mutual fund you’ll invest in. The NAV represents a ‘per-share’ value of the fund – i.e. the price at which the shares would be bought and sold – and is calculated using the following formula: Assets – Liabilities / Total number of outstanding shares.
However, sometimes a fund’s market price will trade either above or below it’s NAV, known respectively as ‘trading at a premium’ or ‘trading at a discount’. This can be due to a few factors. Firstly, supply and demand: if the fund is in high demand and low supply, the market price would usually exceed the NAV, and vice versa. Additionally, performance expectation can have an impact: if a fund is expected to perform poorly, the assets may sell at a discount, and vice versa.
What are the fees for mutual funds?
Mutual funds typically have fees associated with them, and what you’ll pay, in turn, depends on the type of fund you choose to invest in.
Some funds impose transaction charges on purchases or sales in the form of commissions known as “loads”. Other funds charge a redemption fee if you sell shares you’ve only held for a short time.
You’ll also need to pay ongoing expenses to cover the fund’s operational, advisory, management and staff fees, as well as other transactional costs that come with the fund you choose.
How do I buy and sell mutual funds?
You can purchase a mutual fund from the fund itself or through the fund broker. The price you’ll have to pay will depend on the fund’s share NAV, including any additional fees, such as sales loads.
Mutual funds are redeemable, which means you’ll be allowed to sell the shares you own back to the fund at any time you wish. However, you should consider that the selling process can take several days.
Before you purchase a mutual fund, you should read the fund’s prospectus thoroughly. A fund’s prospectus contains information about the mutual fund, including its objectives, performance, expenses and the risks it may be taking.
Is a savings account safer than investing in a mutual fund?
Although investing in mutual funds can bring you high returns on your investments, there will always be an element of risk. In fact, the higher the potential for returns, the higher the risks of an investment. That risk could include losing part or all of your investment. If you don’t want to expose yourself to risk, a savings account might be a better option for you.
Some savings accounts, such as fixed rate savings, provide a set return on your investment, eliminating the risks of investing while offering competitive interest rates.